Economists see the recent rise of the Kiwi dollar making it harder for the RBNZ to reach its inflation targets; central bank seen as having 'little room' to absord downside shocks

Last week’s Official Cash Rate announcement was a “missed opportunity” to nudge the Kiwi dollar lower – or at least ensure it didn’t rise, according to ASB senior economist Jane Turner.

In ASB’s weekly economic newsletter Turner said the rise in value of the NZ dollar after the Reserve Bank’s announcement on Thursday would make it “more challenging” for the central bank to hit its inflation outlook.

“From the RBNZ’s perspective, in the short-term, just getting into the [1%-3% inflation] target band now appears good enough so long as inflation eventually reaches 2% in the ‘medium term’,” Turner said.

“But the RBNZ is leaving itself little room for error. The three-year moving average of the RBNZ’s inflation forecast (a proxy for the ‘medium term’) is bang on 1% until late 2017 (see accompanying chart).

“But we see strong downside risks to inflation. Given the difficulties of inflation targeting once deflation sets in, is undershooting the inflation target band a risk a central bank will take? We think not – eventually. Hence we still expect two further cuts mid-next year.”

Westpac economists were the first among the big banks to pick the OCR going as low as 2% next year. And they are still sticking by that view as well.

They said in their weekly newsletter that the key line from Thursday’s Monetary Policy Statement was: “We expect to achieve [the inflation target] at current interest rate settings, although the Bank will reduce rates if circumstances warrant.”

The Westpac economists said that financial markets appeared to have “latched on” to the first part of that sentence, and had now backed away from the idea of further rate cuts – with the New Zealand dollar in particular has rising sharply since the OCR decision.

“However, the second part of that sentence is just as important. It shows that the RBNZ has moved a step closer to the possibility of taking the OCR below its record-equalling low of 2.5%, an outcome that we have been consistently forecasting since July,” the economists said.

“…The recent upturn in the NZ dollar and falling oil prices mean that inflation is likely to remain very subdued in the near future – the RBNZ’s latest forecasts don’t see inflation reaching the 2% midpoint of its target range until the end of 2017, more than a year later than previously thought. But rather than trying to combat this near-term weakness, the RBNZ has chosen to make use of the flexibility within its policy target, which specifies a focus on average inflation of 1-3% over the medium term.

“However, the risk is that by positioning itself at the lower end of its policy target, the RBNZ leaves itself with limited room to absorb any further shocks on the downside. Our view is that the RBNZ is likely to encounter such shocks in the coming months..”

The economists saw the following three key areas that could provide shocks:

Inflation: The situation around oil prices is quite fluid at the moment, after OPEC’s decision to effectively abandon production targets. But on current fuel prices alone, there is a very real chance that inflation will remain below the 1-3% target band until the end of next year, in contrast to the RBNZ’s forecast that it will rise above 1% early next year. This continued underperformance would make it harder to keep inflation expectations well anchored around the 2% midpoint.

Housing: The RBNZ has assumed that the new tax rules and LVR limits will have only a temporary impact on the housing market. However, the latest figures from REINZ show that the heat is rapidly coming out of the Auckland housing market. Sales have fallen by 27% and prices have dropped by 6% since the new regulations came into force. We suspect that there is further adjustment to come, which should ease the RBNZ’s reluctance to cut rates further on financial stability grounds.

Growth: We don’t dispute that recent data points to the economy regaining some momentum compared to the first half of this year. Indeed, our forecast of a 0.9% increase in September quarter GDP (due Thursday) is a touch higher than the market average. But even this wouldn’t fully make up for the disappointing GDP outturns over the previous two quarters, and even less so when you consider that most of the recent growth in GDP has been a product of population growth. What’s more, we expect that the low dairy payout and an El Niño-led drought will further undermine growth over the first half of next year.

“Consequently, we’ve kept our call for the OCR to be cut further to 2% next year, but we’ve decided to fine-tune the timing of this forecast. Previously we had pencilled in 25 basis point cuts in the March and June Monetary Policy Statements. But given the parameters the RBNZ has set out, it now seems that the more likely date for the next cut is June. Consequently, we are now shifting our forecast to OCR cuts in June and August next year.”

The economists said, however, they “don’t have a high level of conviction about the timing” of any further rate cuts, and would consider any of next year’s OCR review dates to be ‘live’ – with the exception of the next review in January, which they consider would be too quick a turnaround.

“Even so, we wouldn’t be surprised if the RBNZ starts the new year trying to ‘correct’ the market’s perception that further rate cuts are off the table. In particular, the RBNZ Governor delivers an annual speech to the Canterbury Employers’ Chamber of Commerce shortly after the January OCR review; this speech has often been proven to be crucial in setting the tone for the rest of the year,” the economists said.

Meanwhile, ANZ economists, while not predicting the OCR to go lower, did say in their latest weekly newsletter that the risks around inflation “keep the risk profile for the OCR skewed to the downside”.

The ANZ are watching five potential outcomes that could lead to them forecasting rate cuts next year, and say these wouldn’t all necessarily have to be met for such a prediction. The factors they are watching are:

· The NZD continues to diverge from local fundamentals. Despite the possible ongoing strength over the next month or so, we do see the NZD heading lower again over the course of 2016. But the risk is that it doesn’t. And in a world of divergence currencies from localised fundamentals, interest rates must continue to converge.

· Heightened China troubles or export price wobbles. This goes without saying. It is also a risk the RBNZ acknowledges. Commodity price action is terrible, and in terms of New Zealand’s key commodities, dairy prices might have based at low levels but others (including red meat) are on a downward slide.

· Deterioration in global funding markets. We are already detecting some global credit market strains and there is uncertainty over how the market will respond to imminent Fed tightening. If conditions continue to worsen and funding costs lift, then monetary policy will need to ease just to “neutralise” the tightening in monetary conditions occurring via the credit channel.

· Our Monthly Inflation Gauge remains tame. The Q4 CPI data in January will be watched closely. But beyond that, our Gauge will give a far timelier read on whether or not the improved growth backdrop is translating into increased pricing pressures.

· Credit growth settles back to be more consistent with income growth. Some are noting the apparent slowing in the Auckland housing market as a rationale for the RBNZ to cut again. For us, it is too early to make that call yet, particularly with regional markets growing strongly. It is unclear how long weaker Auckland conditions could persist (net migration remains phenomenally strong after all and supply shortages are huge). Therefore, we’d broaden the criteria to overall credit growth. Cutting interest rates further in the face of strong credit growth and deteriorating structural metrics would not be without its risks. Therefore if credit growth slows, then this could give the RBNZ some more OCR headroom.

“Our base case remains an extended period of OCR stability, with the OCR on hold into 2017,” the ANZ economists said.

“And while we agree with the RBNZ that the risks around the growth outlook are now more balanced than they were, we don’t yet think the risk profile around the OCR is as perfectly balanced.”